Why responsible investment matters to the loans sector

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As the European loans market looks to embrace responsible investment, what will this mean for investors and portfolio managers within the sector? Alcentra managing director Ross Curran considers the changing face of the market.

While much focus has centred on the growth of responsible investment and environmental, social and governance (ESG) factors in asset classes such as equities and investment grade (IG) bonds, less attention has fallen on their application in broader credit markets. Until now.

According to the latest updates from industry trade body the European Leveraged Finance Association (ELFA), recent months have seen ESG factors quickly grow to be an increasingly critical part of credit analysis in European leveraged finance.

Now, both ELFA and the Loan Market Association (LMA) are partnering to create best practice guidance to ensure other loan market participants in Europe incorporate ESG provisions in an effective and appropriate way. The resulting guidance will, they hope, clearly set out the key points, terminology and key performance indicators borrowers should consider when integrating ESG factors into loan agreements.

Market progress

Alcentra managing director Ross Curran acknowledges the loans sector has taken time to catch up with more mainstream equity and IG bond markets in addressing responsible investment but says he is encouraged by recent progress.

“Players within the loans sector have been pedalling hard to catch up with some of the broader public parts of the investment market but have taken several positive steps on responsible investment in recent months. For a long time, the credit market was the next frontier for responsible investment – now real progress is being made through bodies such as ELFA and the wider loans industry,” he adds.

According to Curran, one of the challenges still facing the market is its fragmented nature and a lack of consensus about the types and nature of ESG-related disclosures that are required.

Commenting on the current state of play in the market he adds: “Data disclosure on ESG factors and responsible investment continue to be a big issue in the loans market. That said, discussions with investors continue to evolve and there is growing awareness of the importance of data disclosure and the role it can play in assessing corporate ESG risks.”

Beyond disclosures, Curran points to other factors such as changing European Union (EU) and UK regulation on responsible investment – such as the incoming Sustainable Financial Disclosure Regulation (SFDR) – which have helped to heighten lending sector awareness of ESG factors in recent months.

“In the past, companies could be quite relaxed about ESG but changing regulation, the SFDR and the EU Taxonomy – a classification system which establishes a list of environmentally sustainable economic activities – have really prompted them to take a step up over the last year.

“Now, we see industrywide efforts to set minimum standards for companies coming to market with new deals being actively worked on. The number of companies that are increasing ESG or sustainability disclosure as part of their annual reporting to investors has also dramatically increased over the first half of this year,” he says.

According to Curran, lenders can and do use leverage to encourage companies to raise their game on ESG factors and are increasingly aware of the sophistication involved in responsible investing.

“Lenders can have a real impact on corporate behaviour and companies are coming on board with this and are increasingly willing to listen if ESG concerns are raised. Where data is limited, engagement is key. In general, the market is becoming more sophisticated and the landscape is evolving. If an investment firm is trying to promote, say, a collateralised loan obligation (CLO) as ESG friendly just because it excludes investment in weapons or tobacco that just won’t cut it as regulations start to bite,” he says.

Building momentum

While the market familiarises itself with new European ESG-led requirements, there are signs responsible investment momentum is building in the European loans industry.

According to Bloomberg Data, lenders to sub-investment grade companies in Europe are seeing a surge in the number of loans where the interest rate is linked to sustainability targets.

Bloomberg data suggests deals worth more than 25bn euros (US$29.9bn) that came to market this year will pay less if the borrower hits environmental, social and governance goals — or more if they miss.1

Curran adds that devices such as sustainability-linked pricing ratchets – which rely on setting targets for improvements in corporate ESG performance by borrowers in leveraged loan markets – are just one mechanism lenders can use to encourage companies to modify their behaviours.

More broadly, he believes the loans sector may offer some investors a more responsible investment friendly profile than some other asset classes – particularly when it comes to the battle against climate change.

“In some ways the European loan market is well positioned for the shift towards responsible investment as it tends to have a very low exposure to energy and to metals and mining – some of the big carbon emissions driven sectors. The biggest sectors in the market are healthcare and technology companies,” he concludes.

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GE666450 Exp: 17 February 2022

¹ Bloomberg: ‘Ethical Lending Sweeps Into Europe’s Leveraged Loan Market’, 25 June 2021.

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